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Mortgage Interest Deduction Myth

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Farm House with Rising SunThe mortgage interest deduction is one of the most celebrated tax deductions in all of tax deduction-dom. It’s cited as one of the benefits of homeownership, right behind “you’re not throwing your money away,” and that fact is repeated over and over again. Unfortunately, I believe it’s misrepresented. It’s not as good as you think and I’ll explain why.

To claim the mortgage interest deduction, you have to itemize your deductions. For those who aren’t familiar with the idea of claiming itemized vs. standard deductions, you have two options when you file your return. You can either list all of your deductions, such as the mortgage interest deduction, or you can just claim the “standard,” which requires no proof.

The reason why the deduction is a myth has to do with the size of the standard deduction, which you get even if you don’t own a home. Here are the standard deductions by filing status for 2009:

  • Single – $5,700
  • Married Filing Jointly – $11,400
  • Married Filing Separately – $5,700
  • Head of household – $8,350
  • Qualifying widow(er) – $11,400

I recently received my Substitute IRS Form 1098, which is a form my mortgage lender files with the IRS. The form lists, among other things, all the interest I paid towards the mortgage last year – $11,521.87.

If we didn’t have mortgage interest, we would claim $11,400 as our standard deduction and we get that for free. To claim the $11,521.87, we have to pay $11,521.87 to our mortgage company! If you assume we’re in the 25% tax bracket (2010 IRS tax brackets), here’s how we make out from a cash flow perspective:

Married Filing Jointly Single
Itemized Standard Itemized Standard
Interest Paid: $11,521.87 $0 $11,521.87 $0
Deduction: $11,521.87 $11,400 $11,521.87 $5,700
Tax Refund: $2880.47 $2,850 $2880.47 $1,425
Net Cash: -$8641.40 $2,850 -$8,641.40 $1,425
Difference: -$11,491.40 -$10,066.40

Interest paid is how much money was spent throughout the year for each case, so $11,521.87 for the homeowner and $0 for the renter (to use simpler terms). The deduction compares the mortgage interest deduction, of $11,521.87, against the standard deduction of $11,400 or $5,700, depending on filing type. The tax refund is simply 25% of that, since we are assuming the 25% tax bracket. The net cash is to the taxpayer. Take the refund they received and subtract the interest they paid. The delta is the difference between the homeowner and the renter.

As you can see, in both cases, the homeowner pays more. Much more. (and interest, unlike equity, isn’t something you get to keep)

Did you know that you can deduct real estate taxes if you claim the standard deduction? It’s Line 7 of Form L and you can deduct up to $500 (single) or $1,000 (married filing jointly) of your real estate taxes. This makes the mortgage interest deduction even less appealing since you can deduct part of your real estate taxes and claim the standard deduction.

Of course, that’s not the whole picture because there are many other factors. There are tax deductions made available to you whenever you itemize, such as charitable deductions. Also, when you rent, the idea of “throwing your money away” does have a bit of truth in it because you pay for a portion of the mortgage interest and property taxes without getting the deduction for it. Of course, at this point it is more a debate about the broader qualitative and quantitative aspects of the rent vs. buy question.

So why do people buy homes if there’s such a big difference? The difference in what homeowners pay in interest really amounts to what renters pay in housing costs. The table above omitted that because we were strictly looking at the interest deduction, not at housing costs as a whole. People buy homes because when you make those mortgage payments, part of it goes towards the home. When you rent, none of the payment goes towards owning more of that home or apartment. As the years pass and the principal portion of the mortgage payment increases, you get closer and closer to owning a home.

When you look strictly at the mortgage interest tax deduction, it just doesn’t add up financially.

Thoughts?

(Photo: orvaratli)

{ 113 comments, please add your thoughts now! }

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113 Responses to “Mortgage Interest Deduction Myth”

  1. I am a huge advocate of home ownership, but I think Jim is right on this one. Since we purchases our houses on December 30, 2008 this was our first year filling taxes as homeowners. And for those paying attention, yes we missed the $8000 tax credit by 2 days!

    In any event, I feel like my whole life i have heard about how great the tax benefits of home ownership are. I have even had people tell me not to add extra payments to the principle because the interest is a write-off. The results: My wife and I got less of a tax return this year filing jointly as home owners than we did filing single as renters last year. That is with Interest paid being over $15k.

    I still believe home ownership is a much better option then renting, but the tax benefits are defiantly exaggerated.

  2. john thomas says:

    “and interest, unlike equity, isn’t something you get to keep”

    Actually, you do get to keep equity (just can’t, or shouldn’t spend it). Also, once the mortgage is paid off, you own a place. That doesn’t happen when you rent.

    Also, you’re overlooking the fact that property value tends to appreciate (especially over long periods 10-20 years etc…).

    Last thing. It’s pretty rare that someone doesn’t have other stuff to itemize and deduct (charitable giving, medical expenses, unreimbursed business expenses etc.) in addition to the mortgage interest.

    In the long run, especially if you’re staying in one place for a decade or two, it’s far, far better to own, which generally requires a mortgage.

  3. Ben says:

    I don’t feel like the chart paints the whole picture. The chart makes it appear that the homeowner is paying $11,521.87/year that they will never see back (doesn’t go to the equity of the home) and the comparison makes it appear that the renter is paying $0/year towards something they won’t see returned. A more fair comparison would have another entry for rent with a $0 entry for the homeowner and a non-zero entry for the renter.

    Clearly, it all comes down to how much interest you’re paying vs. how much rent you’re paying. That still, of course, ignores the build up in equity (assuming home values actually increase!) over time. As long as you live in the home for 2 out of the last 5 years when you sell the home, you can earn that increase in equity without having to pay taxes which is pretty significant.

    • Jim says:

      It doesn’t go into the equity of the home because I only took the interest amounts from my mortgage.

      It’s also not meant to be a rent vs buy comparison, just a strict look at mortgage interest. I think when you look at it from that perspective the chart makes more sense.

      • Ben says:

        Concur on your first statement. As for your second, that’s fair. However, you wrote, “As you can see, in both cases, the homeowner pays more. Much more. (and interest, unlike equity, isn’t something you get to keep).” To me, that seems to conclude that homeowners are losing money compared to renters, yet the cost of renting is not factored into that statement. Just felt it is a potentially misleading conclusion.

  4. Emilio says:

    in NYC my real estate taxes are over 5K a year so it makes sense to itemize the full amount of real estate tax + mortgage interest. It works out much better that way.

  5. eric says:

    It’s about time someone said this! Totally agree.

  6. Much ado about nothing. Most people (who aren’t 19 or 20) can already deduct quite a bit even if they don’t have a house.

    This article assumes that your options are either “standard deduction” or $0 deduction, unless you have mortgage. This usually isn’t true. Many people can deduct quite a bit, but commonly, not quite as much as the standard deduction, which is why the standard deduction is desirable.

    In theory, the goal should be to be able to deduct MORE than the amount of the standard deduction. For those who make it only part way… the mortgage interest deduction helps them finally get to that point.

    If you have no possible deductions (i.e., you don’t have health insurance, you never went to any doctors that year, etc…) then you’re right, just getting a mortgage for the sake of just barely being able to itemize just as much of a deduction as the standard deduction is a moot point. But this is the rare case, not the norm.

    The other thing that isn’t made clear in this post is the cost of the home. A larger mortgage will mean a larger loan and, therefore, more interest. Maybe where you’re from, homes are cheap. Where I live, the cheapest fathomable home that isn’t in a dangerous area is about $350,000.

    Finally, I have NEVER heard anyone pitching that the reason to buy a home (via a mortgage) versus renting is BECAUSE of the mortgage interest deduction. What I HAVE heard is that people who decide AGAINST potential home ownership cite “mortgage interest” as being a barrier. This is easily debunked by being able to take the deduction. It doesn’t mean you’re not PAYING the interest… just that it isn’t AS BAD as it may appear, at first.

    It’s a pretty simple decision. Do you want to own your home or not? If you are comfortable not owning your home, that’s entirely your choice and there is nothing wrong with that choice. For others, who don’t like the inherent problems with not owning your own home or land and who want to own their own home, the mortgage interest helps to lessen the blow. Interest is a fact of life for those who don’t have the money to actually buy their home. If you don’t want to pay interest, then just save up your money or earn more.

  7. Safeway_Sage says:

    If I ever manage to sell my condo I am never buying another house again. It just doesn’t fit my lifestyle and the deduction simply isn’t worth being tied to a specific place.

  8. thomas says:

    I always deduct more than the standard.

  9. Brad from OC says:

    Am I missing something? The homeowner has a house! Does the non-homeowner not pay rent? If they do, where are those payments in this discussion? Also, this makes no sense if you pay more than $11,400 in mortgage interest and can write off a slew of other things like charity, state taxes, real estate taxes, etc., etc.

  10. EP from IL says:

    I have one question for you… what happen to your property tax??? There are more things that go in itemized deduction then just interest. As Brad said, to the other items. Unless it is the first year after purchasing your home, I hvae never seen the situation that you have talked about

  11. Brian H. says:

    I absolutely agree with Brad from OC. and I can’t believe the first 20 or so comments no one else is seeing the failure of logic. The article compares the cost of owning a house with no housing payment whatsoever, as if by choosing to rent you don’t have to pay rent. You need to add a row in the table for Rent Paid, and another for Mortgage Principle payment, and redo the math. As written, the article compares owning a house with … living in your car? Sleeping on a bench? Living with your parents?

  12. Nikki Smith says:

    Thanks for the break down in this post. I also liked the one you wrote about not buying a house within the first 5 years of graduating. The two posts have helped me make a better decision in terms of whether to buy or continue renting.

    Ever since I started working for a title company, I’ve been gung ho about buying a place of my own in DC. I had it in my head that purchasing property was the lowest risk investment and best choice for me at this point, but it’s so not true.

    I can actually save more money renting under my currently living situation, and your breakdown just reiterates the point. The money will still be there when the time is right for me to buy.

  13. aua868s says:

    any idea if Oregon does this?!

  14. Sam B. says:

    Your math is flawed-in both cases the homeowner has paig the $11,571 of interest. The decision then depends on the value of the tax savings attributable to the method used. If married filing jointly the difference in results is only a few dollars. If single the itemized approach produces a meaningful difference.

  15. wg3254 says:

    What a lame example. You have to assume there is a cash outlay for rent which brings this example back to even. How can you compare paying almost $1,000 per month in interest to zero rent. How ridiculous. Add in the rent and the whole thing becomes just plain stupid. The bonus is all of the other deductions you then get to take which can far exceed the standard deduction. The interest deduction is most likely what is making the itemized deduction possible.

  16. gottabekiddinme says:

    It’s not a myth. Do a line by line comparison over 30 years and see who ends up ahead. The idea of owning a home is like standing on a train platform. It costs money to get on the train. The homeowners are on the train. They all paid different amounts to get on, but nonetheless are still on the train. How much they paid determines where they sit. Most people start in the back and subsequently move up by selling their ticket to the people behind them. The renters are the ones left standing on the platform when the train pulls out. They also have to pay just to stand on the platform; guess who their paying. The people on the train, just for the right to stand there. The next train will cost more to get on

  17. Nikki Smith says:

    I don’t know about this train analogy. I’m an aspiring homeowner, but I’m happy to stay on the platform (my rent situation) for the time being.

    I was all gung ho about buying in this market with the tax incentives (both federal and in the District of Columbia, where I live).

    After crunching the numbers, I learned taking on a mortgage would nearly double my monthly living expenses, effectively cutting my ability to save in half. The money I would get back from tax rebates is not more than I’m able to save in my current rental situation. Sure the money could go into a house, but it’s no longer liquid like it is now, and most of the money would be for interest at first – not equity.

    Don’t get me wrong, I look forward to having my own place one day. But I’m not too worried about missing this train or even if the next train costs more because all this time, I’m only saving more money.

    A larger down payment means more equity to start and a smaller monthly payment, which means more of my assets remain liquid. As much as I like the idea of equity, liquidity makes me feel more secure.

    • Ranny says:

      Nikki,
      I really really liked your point here. When the majority of our money goes into the mortgage, it’s no longer liquid it it is now, it significantly limits your ability of saving money with a decent life quality–even if I knew it go into the principle eventually.

      The market is always up and down. I’m not too worried about if I miss the train. I would rather save more for my down pay in exchange for a lower monthly payment (while hoping for a lower rate). The meaning of “affordable” house is not just simply being able to pay the mortgage, which, in my opinion, is why homeownership has let many people down.

  18. Jack says:

    I don’t know much about this stuff, but if a single person living alone decided to rent out three rooms in their 4-bedroom home to avoid foreclosure on a mortgage that had monthly interest of about $1,800, and the rental income from the four rented rooms was also $1,800, would the mortgage interest deduction wash out the tax liability from the rented rooms?

  19. Jon says:

    I have an opportunity to get a 15 year mortgage and have my new home paid off in 15 years. It would be a little tight but I think I can swing it. A lot of my friends and brother think I am crazy since I will be losing out on the mortgage deduction from the interest. My thoughts are I could alsways buy an investment property and get the deduction there if needed as well as the amount I would be paying in interested seems to far outweight any savings the interest decuction would give me. Thoughts anyone?

  20. bsj2312 says:

    I don’t understand the logic in this article. Why would your itemized deductions ONLY include your mortgage interest? Of course it doesn’t make sense like that! You have to include your other itemized deductions, also.

  21. TheNextTrump says:

    I think the rental aspect is a crucial item to include in your analysis. Once you start talking cash flow, you’ve taken it a step beyond a simple analysis of the difference between claiming the standard and itemizing. It is more thorough to analyze the respective cash positions if you itemize with a mortgage, take the standard without a mortgage but don’t rent, and take the standard with rent. As you noted, paying rent levels the playing field, so it should be included in your analysis because it is so significant.

  22. Bo says:

    I’m pulling $$ from my tax-free savings account to pay for my home.

    The added tax due is almost identical to the mortgage interest, so I’m ‘breaking even’ so to speak.

    I won’t live long enough to get my mortgage interest down that much, making my taxes go up.

    Interesting article.

    Bo

  23. Pankaj says:

    These calculation does not take in account of property tax, state income tax, local income tax, vehicle tax etc are eligible in itemized deduction. Also it does not take in account of benefit of 2% annual home price appreciation. Yes there is cost of maintenance of property.

  24. Useyourmind says:

    Without getting into the details financially or economically, that is one of the worst arguments I’ve read in quite a while. It seems grown out of the complacent American bias that “the government is always trying to screw me.” the worst part is that, if this website gets enough traffic, there is at least one person out there convincing people not to buy a house because the “mortgage interest deduction is a sham.”

  25. Dave says:

    Folks….I haven’t seen any comments on the fact that with all good mortgage interest, comes fat property taxes which must be included….can’t have one without the other…especially in the northeast.


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